Ok, so Citi is out with something pretty interesting on XOP.
So far this year, Energy equity has been more adept at pricing in risk from gyrations in crude prices than Energy credit.
This probably reflects the extent to which credit markets are still distorted by the never-ending, central-bank inspired hunt for yield. And indeed, this dynamic is exacerbated when supply dries up, as investors clamor for whatever there is to get, thus providing a demand-side technical that supports further spread compression.
Over the past two months, HY Energy issuance essentially flat-lined. You can plausibly attribute that development to no one needing to refi if you like, but it’s worth noting that spreads are becoming more responsive to crude, which suggests the environment is becoming less favorable – if only slightly so:
In any event, the point is that equities are probably a better barometer of market sentiment when it comes to how everyone is trying to price the outlook for crude prices.
And when it comes to equities, Citi thinks XOP is perhaps “the most relevant US listed ETF for assessing energy stock read-throughs.”
That makes sense from a sort of high-level, common sense perspective because as the bank writes, in a note out late this week, “XLE’s integrated exposure lessens its oil price leverage.”
Of course divining anything from ETFs is complicated by a number of factors. For instance, the broad-based sector exposure they offer and the intraday liquidity they promise (even if that liquidity is largely illusory) makes them ideal as hedging vehicles. Or, to give you another example of how these things are multi-purpose, bond fund managers can use corporate bond ETFs as liquidity sleeves (i.e. as a substitute for cash buffers) thus allowing them to remain fully invested comforted by their (likely misplaced) faith that the ETFs can be sold immediately to manage outflows.
So with all of that as the backdrop, below, find some excerpts from Citi’s note which explains how XOP is being used vis-a-vis crude…
The bigger picture context is that investors need to be aware that different ETFs are used for different purposes. Frequently, there is one ETF which becomes the “goto” vehicle for tactical purposes for a given market segment. Within Energy, XOP has emerged as that vehicle.
In particular, our soapbox commentary regarding ETF flows has been that they require interpretation, and cannot be viewed as apples to apples with mutual fund flows in assessing underlying stock impacts. One key distinction is that ETF shares can be sold short, while mutual fund shares cannot. In the case of XOP, the data in Figure 2 provides a clinic for this. That is, since the mid-’14 energy complex peak, there has been a significant “negative” correlation between XOP flows and price action. We argue that this reflects its role as a hedging instrument. Thus, XOP experiences inflows as investors rush to hedge when energy stocks are falling, and outflows as hedges are lifted coincident with rising prices.
Most recently, flows have exceeded those experienced at the sector lows in late ’15- early ’16. Importantly, a flow crescendo was reached concurrent with an ETF price bottom on June 21.
An obvious question is how this relates to short interest. Well, this is a bit more complicated. But, while there is a directional relationship between XOP flows and short interest, the correlation is solid, but less meaningful (see Figure 3). Our interpretation is that not all of an ETFs flows can be attributed to one type of trader/investor. Certainly, there have been many points during this year where an investor may have chosen to take a long positioning stand on the sector.
That said, a very clear relationship between XOP price and the short interest ratio exists (where the ratio is defined as short interest/shares outstanding. However, the relationship is counterintuitive.
Over the past three years, XOP price action has coincided directionally with the short interest ratio. Essentially, this speaks to XOP’s use as a hedging vehicle. Generally, investors have gotten it right, having reduced hedges as the ETF has fallen, and increased them as it has risen. The current short interest ratio is not yet to the early ’16 low. But, it has come in significantly from late ’16 levels.
Be sure to note that this ratio had been higher than 200% back in mid-’14. Many investors ask how this can be. The answer is that it relates back to ETF structure and, in this case, the ease of creates/redeems vs. the underlying stocks. As a result, the marketplace is comfortable shorting an ETF more than once on the premise that any call-ins can be addressed via new creates.